A Deepfuckingvalue-esque Analysis! (Part 1) (Patreon)

After talking briefly about DFV a few posts ago, I wanted to do a more comprehensive analysis using the strategies that he uses. There are so many great practical tips he gives his viewers on all of his streams, and I wanted to relay them to you guys. 

If you haven't ever watched any of his content, I'd highly recommend watching all of it. It's a great look into the mind and strategies of a real contrarian whose ideas actually played out to make tens of millions of dollars. 

lol

Deepfuckingvalue Youtube channel 

WHERE ELSE can you watch the entire analysis process from someone who actually made thousand percent returns. On my channel you watch the analysis process from someone who makes -100% returns. 

If you're actually serious about investing, I'd highly highly recommend checking it out.  

Alright. Deep value. Where to begin. 

I want to make this as practical as possible. No abstract ideas about "just be a contrarian" or "find undervalued companies". What does that even look like in real life? How the fuck do I go about doing those things right now? 

So instead of going over the top with conceptual ideas, we'll look at the actual ways you can start doing this stuff at home on your computer right now. 

I think what you might find is that the practical aspects of this aren't incredibly complicated or difficult. The difficult part comes with your diligence and psychology. 

1. Are you disciplined enough to do this process over and over again without wanting to kill yourself? 

2. Are you patient enough to hold your money when there are no opportunities?

3. Are you confident enough to trust the strategy even through periods of underperformance? 

The problem is that when in the thick of it, you won't recognize these things as purely psychological problems. For example:

Let's say you buy a stock following the same steps we're about to talk about. It's incredibly cheap, has plenty of insider buying from prominent execs, and great historical operating performance. 

The only problem is the share price continues to trade sideways and down for months. Not uncommon for a lot of these deep value companies. After a while, your brain will start to rationalize 10,000 reasons why your wrong 

Unfortunately I don't really have any practical advice on how to overcome this? It's just an important thing to keep in mind. At the end of the day, you're the one pushing buy and sell. Without control over your emotions, and self-awareness of your cognitive bias, your eternally fucked. 

Now that we have that out of the way, let's talk briefly about the theory of contrarian deep value investing; Deepfuckingvalue's strategy. 

I know. I'm sorry. I said no theory. You can skip this if you want, but I think understanding what DFV is trying to do and why it works will help you have confidence in the strategy. Confidence in the strategy means less psychological bullshit, more sleep, and more money. 

I'm gonna try to keep this brief - 

What we're trying to do is buy into companies that are at the bottom of some kind of business cycle. In every scenario, there's a reason these companies will look like they're destined for failure (just like $GME). However, finding companies with a track record of good performance, that are currently in a period of terrible performance, is a strategy that has actually proven to perform very well over the long term. 

Relevant video about relevant book 

Why on earth would this actually work?

Why would we intentionally buy into companies that are obviously in some kind of distress?

The short answer is mean reversion. There's been a ton of research studying companies that are performing very well, vs companies that are performing poorly. Companies that perform very well tend to only do so for a short period of time before reverting back to lower levels. Companies that are performing poorly tend to revert up to a more normalized level. In both cases, there tends to be some kind of an equilibrium point that's reached. This is very consistent throughout stonk market history.

A lot of this can be attributed to competition. Well performing companies tend to quickly attract competitors, and poorly performing companies tend to attract private equity firms and activist investors. The net effect of these two things is companies seeing periods of outperformance or underperformance before reverting back to some mean level.  

On top of that, as humans we tend to linearly extrapolate growth and decline trends more than we should. There's always a reason why "THIS TIME IS DIFFERENT!!". Historical data shows that this is almost never the case.

There are two ideas that make deep value investing the perfect strategy for the retail degenerate. 

Implementation of deep value strategies becomes significantly more difficult (if not impossible) the more money you have. The companies experiencing these mean reverting trends are often too small for big money managers to come in and play; there's simply not enough liquidity.

Beyond that, you have to consider the marketing aspect of managing money. Buying into bad companies in depressed sectors isn't a strategy that tends to attract investor money. So even though the strategy might be proven to work, it's very hard to implement with other people's money. Being that institutions trading other people's money usually have the most time + resources to do so, it's good that they aren't able to dabble in this space as much. 

Both of these things are great for you and I.

Enough theoretical BS. If you want to learn more, I'd recommend looking into some deep value backtests online. 

1. Screening for deep value

There are a lot of different valuation multiples people use to compare companies on a relative basis. Some backtests have shown that purchasing stocks solely based on these multiples is a strategy that has outperformed the market for long durations (30+ years) by 5-10%. This is one of the fundamental ideas of deep value investing. 

DFV doesn't talk specifically about his initial screening process, however being that he considers himself a deep value investor, I'm guessing it looks something like what we're about to do.  

The most commonly referenced screen for deep value stocks is EV/EBIT (enterprise value / earnings before interest and taxes)  

For the sake of keeping this relatively short, I'm not going to go into why EV/EBIT tends to be a more powerful valuation multiple than something like P/E. There's a ton of backtesting data that's shown it to be the most effective valuation multiple to use when looking for deep value opportunities.

There are tons of different ways to find deep value opportunities, this is just one of the most direct.

If you want to learn about why  EV/EBIT is an effective valuation multiple, this is a good place to do so.  

We're going to be using StockRover to setup our screen. It doesn't really matter what screener you use, StockRover is just one of the only ones I've found that allows you to screen directly for EV/EBIT. You can sign up for a free account which gives you access to all the tools you need.

If you click on Add Criteria, you can then find EV/EBIT.

You're then going to want to turn off all the other criteria and set your filter to EV/EBIT between 0-8. I'd recommend starting as low as possible and working your way to higher multiples. 

Another great way to do this might be to start with broader macroeconomic trends. Research what market sectors have been underperforming recently and narrow down your search criteria to only those sectors with a low EV/EBIT multiple. 

Now that we have our list of companies with low EV/EBIT multiples, the fun begins.

We're going to be looking at a few different criteria to try to recognize value. Keep in mind that the key is to start building a database of companies as well as the prices you'd want to buy them at. 

So even if a company we're looking at doesn't exactly fit our buy criteria right now, there may be a future point where the share price is low enough to make it a worthwhile purchase.  We want to make sure we've established what that point is early on so we can jump on opportunities quickly when we need to. 

So how does DFV recognize untapped value? There's a few key points we're going to focus on. 

These are also just examples of different things that might help you recognize value. You can weight each of them in your strategy how you'd like. One of the most valuable things you can do is backtest the importance of each of these factors in creating outsized returns. 

For example: 

What would have happened if I were to have bought purely based on insider buying? 

What would have happened if I were to have bought 10 of the stocks with the lowest EV/EBIT multiples last year regardless of any other factors? 

What are the real variables that contribute to excess market returns?

The goal is to modify/add to these criteria based on what you find works best:

1. Low EV/EBIT multiple

2. Good historic operating performance

3. Insider buying from high level executives

How are we going to capitalize on these opportunities when we find them? 

DFV shoots for 50-100% returns per year. A lot of that is purely from buying shares, however he also doesn't shy away from attractively priced call options. If you want to read more about that, we talked about it on a previous post about DFV. 

Let's take a look at Boise Cascade ($BCC). I just randomly picked a company from the list. BCC is a small cap building material distribution company that's trading at around a 4.1 EV/EBIT multiple.  

Looking at TIKR Terminal, (another great free website you should use. It will say "join waitlist" when you go to their website, but it usually takes only a few days for them to grant you access) we can see that they're trading at a very low EV/EBIT multiple relative to the past. 

When look at EV compared to forward EBIT down below, we can see why our valuation appears to be so low.

BCC is a lumber proxy; its price is correlated highly with lumber prices. With the insane run up in lumber prices, its seen a significant increase in earnings temporarily. Being that this is purely a cyclical increase, the market's now pricing in the inevitable decline in earnings. 

Our low valuation is just the product of short term economic tailwinds creating overly-inflated earnings. Not what we're looking for.

However just briefly analyzing this one company tells us so much about where we might be able to find deep value opportunities.

We now know that companies with any correlation to lumber prices might have misrepresented low valuations. Though appearing to be "cheap" companies, it's purely the product of fortunate economic conditions. 

I'm going to cut this off here for this week. 

There's so much to talk about when using DFV's investment strategy. By the end of this my goal is to find multiple deep value opportunities that we can lose money in. 

Next week we'll get a lot more analysis on specific companies. Just trying to lay the groundwork first. 

Part 2 coming out next week!